Speech
The Economic Landscape in 2009

Thank you to Australian Industry Group for the invitation to speak here today.

I'd also like to take the opportunity to say how much I appreciate the good
working relationship that we've had with Australian Industry Group over
the years. Talking with businesses is a very important part of our work at
the RBA and an important input into our reading of the economy. That's
especially so at a time when the situation is changing as quickly as it has
been in the last few months.

When I spoke here a year ago, I commented on the contrasting trends that were being
observed across different parts of the global economy. It was already apparent
at that time that the United States and a number of the other advanced countries
were entering a period of significant weakness, flowing from the early effects
of the financial crisis. In contrast to that, China and much of the developing
world were still growing rapidly. They were generating strong domestic demand
and that was, in turn, underpinning global demand for commodities. Australia
was one of the main beneficiaries of the high commodity prices that resulted
from that.

That was the situation a year ago and, in broad terms, these conditions persisted
well into 2008. Up until the September quarter, China and the other developing
economies in Asia mostly kept growing reasonably firmly, and world commodity
prices were still close to their peaks.

But events since then have taken a sharp turn for the worse. In the December quarter,
the downturn in the G7 economies intensified, and at the same time it spread
to other parts of the world, including Asia, Latin America and eastern Europe.

Graph 1

Based on the information available to date, we estimate that GDP in Australia's
major trading partners contracted by 1½ per cent in the December quarter.
The falls in output were widespread, but they were particularly pronounced
in the Asian region. Output in Japan fell by 3 per cent in the quarter, and
contractions of the order of 6 per cent were recorded in Korea, Taiwan and
Thailand. China's economy continued to grow, but at a much reduced pace.
For the smaller Asian economies, these recent falls in output are comparable
to what occurred in the 1997 crisis period. For Japan, it's the biggest
fall since 1974.

Table 1: Australia's Five Largest Export Markets

Per cent

Share of Australia'smerchandise exports

GDP growthDec quarter

Japan

19.3

-3.3

China

14.9

0.6

Korea

7.9

-5.6

Euro area

6.2

-1.5

United States

5.9

-1.6

There were a number of factors that contributed to this sudden deterioration. The
most obvious trigger was the collapse of the US investment bank Lehman Brothers
in mid September. It was followed, in fairly quick succession, by a string
of other announcements of the failure or near-failure of institutions in the
United States and Europe. The general turmoil was heightened by intense uncertainties
about the nature and scope of various rescue proposals that were being put
forward by the governments concerned.

These events brought on a large-scale re-evaluation of financial risk around the
world, and a major loss of confidence, both in financial markets and amongst
households and businesses. In the weeks that followed, particularly through
October and November last year, equity markets recorded some of their largest
daily movements in history. In net terms, they fell by around 30 per cent over
that period. They have since fallen further, though at a slower rate.

Graph 2

The financial turmoil was accompanied by a sharp decline in survey-based measures
of business and consumer confidence around the world. Households and businesses
seem to have made a rapid re-appraisal of their spending plans, and in particular
they cut back their discretionary spending. One very clear example of that
was a sharp drop in the demand for motor vehicles in the final months of last
year.

In fact, demand for manufactured goods has weakened more generally. We can see the
effects of that on global industrial production. After growing at an average
rate of about 6 per cent per annum over the last few years, it fell by 10 per
cent from its peak over the final months of 2008.

Graph 3

So the shock to confidence that followed the Lehman collapse seems to have been a
major factor in the recent global deterioration. But there were also other
factors at work. One was a further tightening in credit standards in the major
economies. This showed itself, among other things, in disruptions to trade
credit and insurance, and in a tightening of lending for consumer and business
spending.

Another factor was the rapid transmission of these effects around the world through
trade linkages, as businesses cut back on production in response to reduced
orders. The graph illustrates the unusually large falls in exports and imports
that were recorded across the major economic regions in the final months of
last year. This included export falls of the order of 20 per cent or more in
Japan and some of the smaller east Asian economies. Thirdly, there seems to
have been a sharp inventory adjustment in a number of countries, as firms cut
back production in response both to weaker-than-expected demand and reduced
availability of working capital.

Graph 4

Most of the gloomy economic news that I've just described relates to the December
quarter of last year. We don't yet have sufficient data to get a good
reading on the trends that might be emerging in the early part of 2009.

But, in thinking about the outlook, it's important to recognise that governments
and central banks around the world have taken some very significant steps to
support growth. Interest rates have been cut to low levels in most countries,
and there are some very large fiscal policy initiatives in the pipeline around
the world. In a number of countries, including the United States and China,
discretionary fiscal expansions of the order of 2 per cent of GDP look like
being implemented in the next couple of years.

Table 2: Discretionary Fiscal Easing – Selected Economies

Per cent of GDP

Estimated easing*

2009

2010

United States

1¼

2¾

United Kingdom

1¼

½

Germany

1½

¾

Japan

1¼

-

China

over 2

over 2

South Korea

over 2

over 2

Taiwan

over 2

over 2

Australia

2¼

1¾

*Based on policy announcements and media reports

In addition to that, the major economies have taken a range of steps to provide direct
assistance to their financial sectors. These have taken several forms –
including central bank actions to improve access to liquidity, direct injections
of capital into financial institutions and the provision of government guarantees.

More needs to be done in the major countries on this front. But there are some tentative
signs, at least, that these steps are contributing to some improvement in the
functioning of financial markets. The extreme volatility that followed the
Lehman collapse has eased off in the last couple of months. And the availability
of government guarantees has seen a recovery in bond issuance by banks around
the world. This is helping to put banks in a position where they can be more
confident of their long-term funding.

Overall, there's no doubt that 2009 is shaping up as a very difficult year
for the global economy. IMF forecasts released in late January were for world
growth of half of 1 per cent this year, with the G7 economies contracting
by 2 per cent. If these forecasts are realised, it would amount to the weakest
year for the global economy, and for the advanced industrial countries, in
the post-war period. The forecasts do, however, imply some pick-up towards
the end of the year and into 2010 as the expansionary measures take hold.

Graph 5

How are these global developments affecting Australia?

Given the abrupt deterioration in the world economy, it won't be possible for
Australia to avoid significant short-term weakness. We'll have some more
information later today, when the national accounts are released, about how
the economy performed in the December quarter.

But prior to receiving that, it's worth noting that the Australian economy
came in to this crisis period with stronger momentum than most other advanced
economies. On the latest figures we have (which of course are subject to revision
later today) GDP expanded by just under 2 per cent over the year to the
September quarter. Comparable figures for other economies over that period
were 0.7 per cent growth for the US, a similar figure for the euro area, and
a contraction of 0.2 per cent in Japan. Growth of domestic spending in Australia
over the year was even stronger, at 4 per cent.

Labour market indicators, which are more up to date, suggest that, even though conditions
have weakened recently, the Australian economy remained more resilient than
many others. Total employment was up by 1 per cent over the past year.
The unemployment rate has started to rise, but it's still historically
low.

Graph 6

Nonetheless, recent events clearly represent a major change to the environment for
the Australian economy from the one prevailing as recently as six months ago.

One important dimension of that is the effect on Australia's terms of trade
– the ratio of our export to our import prices. In broad terms, the recent
movements summarise the effect on national income from the changing relative
price of Australia's resource exports. Over the past five years, rising
world commodity prices have lifted Australia's terms of trade by an average
of 10 per cent per annum – the largest cumulative increase since the
early 1950s. In the year to the September quarter, which is when the peak was
reached, the increase was 20 per cent. The effects from all this have been
seen, among other things, in the boom in mining and construction over recent
years, with significant spillovers to the rest of the economy.

Graph 7

It now looks likely that this last 20 per cent rise will be roughly reversed in the
year ahead. That will still leave the terms of trade at a high level, but in
the near term, it means this effect will be subtracting from, rather than adding
to, the growth of national income. On a more positive note, it's worth
pointing out that the very sharp falls in resource commodities prices that
occurred in the December quarter don't seem to have continued in the
early part of 2009.

Graph 8

Another way that the global crisis has begun to affect Australia has been the impact
on business and consumer confidence. The survey of manufacturers conducted
by Australian Industry Group shows that there's been a sharp decline
in perceptions of current conditions over recent months, with the biggest falls
happening in October and November. That result is not surprising, given the
drop in global demand for manufactured goods that I discussed earlier.

Graph 9

The broader NAB survey, which has a longer history, reports that confidence across
the non-farm economy has fallen to levels comparable to the trough reached
in the early 1990s. It's interesting to note, though, that the indicator
of actual business conditions from the same survey has fallen noticeably less,
by an amount more akin to the slowdown in 2001.

Graph 10

Consumer confidence also fell during this period. But relative to history, the fall
in Australia seems to have been less pronounced than what has occurred elsewhere.

Graph 11

Overall, these falls in confidence can be expected to weigh on spending decisions
in Australia, as they have elsewhere in the world. But I'd like to make
a couple of more positive observations.

First, regarding the business sector, last week's capital expenditure survey
reported continued strength in investment spending through to the end of 2008.
In fact the recent period has been one of remarkably strong investment, with
growth averaging in the double digits for the past five years. The high level
of investment will in turn have longer-term benefits for the growth of Australia's
productive potential.

Graph 12

It's to be expected that, in an environment of weak global demand, falling
commodity prices and reduced confidence, investment plans are going to be wound
back. The expectations component of last week's survey confirmed that,
as have a range of earlier private-sector surveys. I don't want to downplay
all that, but it's worth making the point that investment spending in
Australia did finish 2008 with a surprisingly strong overall momentum, given
the very unfavourable global backdrop.

A second point to keep in mind concerns the household sector. At present, household
disposable incomes are getting a substantial boost from the combination of
falling net interest payments, fiscal transfers and falling petrol prices.
We estimate that in the past two quarters, household interest payments have
fallen by an amount equivalent to about 5 per cent of disposable incomes –
a sizeable cost reduction especially over so short a period. I recognise that
these effects are not evenly spread across households. For households who are
interest receivers, there is a loss of income from that source. But for the
sector as a whole, the net effect is a significant addition to disposable income,
which in turn can be expected to support spending.

Graph 13

In addition to that, fiscal transfers of the order of 3 to 4 per cent of incomes
are being paid out to households through the December, March and June quarters.

The main effects from these income gains still lie ahead, but we saw some early effects
with a sharp rise in retail sales in December. We learned yesterday that those
gains were maintained in January, with a further rise in sales occurring in
the month.

As we think about prospects for the Australian economy, the RBA has also been making
the more general point that our financial system is in much better shape than
its overseas counterparts. The reason why we have been able to have the large
reduction in household interest costs that I just described is that the monetary
transmission mechanism is working. Reductions in the policy interest rate have
flowed through substantially to end borrowers. That hasn't been the case
to anywhere near the same extent in the United States and some of the other
major economies. We're seeing some early effects of these interest rate
reductions on household demand for finance, with loan approvals starting to
pick up over the final months of 2008.

Graph 14

Let me summarise briefly.

There's no doubt that world economic conditions deteriorated sharply in the
final months of last year. Governments and central banks around the world have
taken actions to support growth in response to these events, and to assist
their financial sectors. But these measures will take time to work, and 2009
is looking to be a very tough year for the global economy.

Australia is being affected by these events. The international deterioration has
been so abrupt that it won't be possible to avoid some short-term weakness
here. Nonetheless, Australia came into this period with better momentum than
most, and with more scope than most to take expansionary policy measures. That
scope is being used. The transmission channels are working, and we can expect
the measures that have been taken will increasingly support demand as the year
goes on.

Thank you again to Australian Industry Group. It's been a pleasure to participate
in this event over the years, and I thank you for the invitation today.